New Drilling Technology Could Finally Make CBM Very Economic

In a previous interview about coalbed methane (CBM), Sprott Asset Management CBM analyst Eric Nuttall told us he would remain, “quite excited about the prospects for companies with coal bed methane assets so long as natural gas prices remain above $6 per Mcf (thousand cubic feet). The economics would be very skinny under $6.” That’s because CBM exploration and development can get pricey. What if there was a drilling firm regularly bringing gas out of the ground for under $1.50/mcf? There is and they’ve proven it with more than 250 wells in Australia. They’ve moved into India, where they drilled another 30 to 50 wells and another 70 wells to come. Mitchell has taken acreage in southern Kansas, where the company just finished its first CBM well. And the company formed a joint venture with Pacific Asia China Energy (TSX: PCE) to bring its Dymaxion® technology to China later this year. You don’t get to be Australia’s largest privately owned drilling company without timing your markets right. The Mitchell family’s great timing ability began in 1969, when company founder Peter Mitchell bought his first drilling rig at a repossession sale for $11,500. Parts of Queensland, Australia were in the grips of a drought. Mitchell put his rig to good use as he began drilling water wells for farmers in the surrounding rural counties. Just as the drought had ended, Mitchell caught the boom in coal. His growing company began drilling in the oil shale and coal fields around Moranbah, then a remote part of Queensland. They then caught the drilling boom in mineral resources through the 1980s. By then, the company was drilling oil, gas, uranium and coal reserves throughout Australia. In the 1990s, Mitchell Drilling got the first whiff of Coalbed Methane (CBM) exploration entering Australia. That is when the major U.S. oil companies, such as Amoco, Conoco and others, came to the country searching for new CBM fields. But, the major U.S. oil companies abandoned CBM in Australia because they soon discovered Australia’s shallow coal fields were too expensive for their big oil rigs. “The economics just didn’t work,” Nathan Mitchell told StockInterview. “They needed high gas flow, but the fracing technique just didn’t give them what they needed.” Still they persisted and asked Mitchell Drilling to run his smaller water well rigs. “That was the start of it,” Mitchell recalled. “We made CBM work with the water well rigs from an economics point of view, but they still weren’t making enough gas.” Still, the economics of the smaller rig made it work to a degree. Enter the politicians. “The Queensland government made a law that said five percent of all coal-fired power stations had to be run by gas,” explained Mitchell. “That spawned the industry and CBM really took off.” Mitchell continued with the vertical rigs, but it was the economics of the smaller rig that made CBM work. GETTING BLOOD OUT OF A STONE It was during the CBM boom when Mitchell developed the better mousetrap. Coal miners didn’t see the gas resource beneath their feet. “They just saw them as coal fields,” said Mitchell who knew there was “nuisance gas” there. “There was never even a thought there was enough gas there to make it viable.” With natural gas selling for $2/mcf in Australia, the economics didn’t make sense. Australian coal seams are found at shallower levels where greater pressures have to be created to liberate gas from the extended horizontal seams. The Australian one-two punch of shallow coal seams and low gas prices drove Mitchell to become innovative. “We’d seen in the coal business the underground in-seam drilling of horizontal holes and degasification,” Mitchell explained. “But, there was usually a lot of water involved and no way to get the water out.” Because of the company’s decades of experience in drilling water wells, Mitchell combined the vertical well with the horizontal well. Mitchell described the process, “The vertical well became the conduit for the coal mine, the gas and the water, and gave us a huge surface area. Suddenly, in areas where there wasn’t a resource, we could produce something like a million or up to 2 million a day from these Dymaxion® wells.” The technology was put to the test in central Queensland, Australia. An Australian newspaper reported in June 2004, “In an industry where tradition plays a strong role, innovative drillers Mitchell Drilling have chalked up the 100th example of their revolutionary Dymaxion surface to in-seam (SIS) methane gas drainage hole for gas producer CH4 Limited at their Moranbah gas project.” CH4’s website spoke highly of this gas project, “The Moranbah Gas Project will utilise innovative drilling and gas extraction techniques, allowing increased potential gas yields while leaving the coal resource undamaged.” How does this impact the industry? “We see this as revolutionary,” Mitchell cheerily remarked. “It has changed the face of CBM. It works in areas where people didn’t think it would work.” For example, the Dymaxion® drilling works in high permeability with low gas. “We can get such high gas from low gas content reservoirs, where people didn’t previously think there were reservoirs.” It has worked in Australia, where every penny counts. “Our price may cost around $1.25 or $1.10 (US$) per mcf so they are still making reasonable profits at around 50 percent.” How will it play outside of Australia? Mitchell shot back, “If you can imagine costs at $1.25 and you’re selling it for $6/mcf, that’s some pretty good bloody profits.” Drilling at reasonable profits for $2 gas, Mitchell said, “We are keen to take this technology around the world. Even if we were to double our costs, our clients would still be extremely happy.” USING BOTH VERTICAL AND HORIZONTAL WELLS When discussing the Dymaxion® technology with an oil and gas man, his puzzled response was, “Did I hear you right? You are using both a vertical and horizontal wells to get the gas?” There are the skeptics. “Contractors from the larger oil and gas companies came over to have a look,” Mitchell said. “Some people thought we were sliding by or sort of skimming costs.” He explained the procedure, “We have to intercept (the vertical) because we actually line up every one of our lateral wells with a slotted liner, a perforated liner. It is stacked into the vertical well, by the arrangement we’ve developed, so we know we’ve intercepted it.” Mitchell said the key is the ability to flush and know that the finds are coming out. “We can have a number of wells lined, going from one point to another,” he explained, “and we’ve got continuity of connection and flow between one well which is 1000 to 2000 meters away and the vertical well. We can flush between both.” He gave an example, “We can have three horizontals going into one vertical and two of the horizontals can be closed. Number one can be opened and flushed; then number two can be open, flushed and closed. So you have this over the 10 to 20 year life of the well.” How does the SIS hole de-gas a greater area than a regular horizontal? “When we put two wells into a chevron pattern, you start to get absorption between the V at the start of the well,” Mitchell said, describing the Dymaxion process. “Once you get the wells done, in a V with each other, you start to get better flows, a bit more gas and greater increasing gas in a slow decline.” Mitchell’s website does admit the old technologies may be suitable for deeper drilling, “In the case of very deep deposits, up to 3000 meters underground, a vertical well may be adequate to create sufficient water table pressure to liberate and bring to the surface large quantities of methane gas.” Because of the greater surface area draining the underground gas in the coal seams, the same website is quick to point out, “SIS drilling also provides valuable exploration data on seam rolls and faults, allowing greater certainty in mine planning and development.” The SIS process begins by using modified, multipurpose mineral drill rigs with specially designed bottom hole assemblies. In the SIS technique, a hole is drilled at 60 to 90 degrees from the surface. It is then steered through a medium radius bend to horizontally enter the target coal seam. The 96 millimeter hole is steered in the seam toward a previously drilled vertical production well. A homing device is lowered down the vertical well to the target seam, which helps the horizontal hole intersect the production well. The vertical well dewaters the seam. Once the hydrostatic head has sufficiently been lowered, gas flows to the surface. MITCHELL’S WORLDWIDE EXPANSION Developing the Dymaxion® technology in the late 1990s, the first test took place in Australia in the year 2000. Now, going on nearly seven years later, the company has drilled more than 250 wells in Australia, another 30 to 50 wells in India with another 70 more to drill, and has moved on to both Kansas and China. Mitchell talked about Kansas, “We finished our first well, but we don’t really want to be a contractor in the United States. We don’t see a lot of benefit to handing over our technology, but we would be interested in doing some sort of equity deal or partnership with clients.” He believes that in the right areas, what Mitchell has got is “exceptionally good.” So where did Mitchell first make an equity deal? “The two big powerhouses of the world for the future are going to be China and India,” he noted. “Both of them will have energy problems in the future. Mitchell’s first equity deal came about with Pacific Asia China Energy. “We just astounded them with what was happening in Australia,” Mitchell laughed, “to see this small compact rig drilling 2000 meter holes of a well and making it work at $2 gas.” He explained that although rigs were cheaper in China, the logistics, the costs of roads and access for trucks and pumps, gear and equipment, costs start to go up. “It like a U.S. aircraft carrier,” Mitchell compared with a drilling operation, “you have 40 planes on deck but it takes 70 people to run it.” Even in China, costs can go up when running these logistics. The deal with Pacific Asia China Energy involves reduced drilling costs and a 50/50 arrangement for income produced through the use of the Dymaxion® technology in China. The joint venture company has exclusive use to this technology in the world’s largest coal producing country, China. How does Mitchell see business growing in China? “Exponentially,” he quickly replied. “In China, there is a push to degasify their mines. There are some several thousand large mines, many with over one hundred million tons in reserves, and a lot of mines are being shut down because of degasification problems.” In an earlier interview with the Tunaye Sai, president of Pacific Asia China Energy, he reported that every single coal company at a recent symposium approached both Mitchell and himself about the Dymaxion technology for China. Was that true? “Very much so,” Mitchell confirmed. “Mine safety is now at the forefront of China and international observation. They’re looking forward to international help and technology to come to China and fix these problems. They’re looking at it from they want to sell coal, but they also want to sell gas. It worked well in Queensland and will apply to in China. That’s why we see such a growth for Mitchell.”

Sprott Analyst Has Zero Doubt on Higher Natural Gas Prices

Introduction: We talked with Sprott Asset Management Research Analyst Eric Nuttall about the natural gas situation in Canada and the fate of many CBM gas producers and developers. Since our last conversation spot natural gas prices have dropped by 15 percent. Natural gas storage levels are about 2.5 trillion cubic feet, some 423 billion cubic feet higher than a year ago. Eric Nuttall told us, “Nearly all small-cap natural gas producers have taken it in the teeth this year. The price decreases in their stocks have been absolutely brutal. There are now companies whose stocks are down 40 percent year-to-date, and yet are still strongly growing production on an adjusted share basis.” How will the CBM and natural gas sector pan out through the end of this year? He believes the gas storage surplus will correct itself. StockInterview: How are the lower natural gas prices impacting Coalbed Methane producers? Eric Nuttall: For many CBM or shallow gas producers, this means their current drilling program is likely uneconomic, suggesting deferrals in drilling programs until natural gas prices strengthen. It is this very supply response that we need to balance storage levels, so it should not come as a complete surprise. StockInterview: What, then, should investors do while storage levels are rebalancing? Eric Nuttall: I would view this period as an opportunity for medium to long-term minded individuals to start building positions in not just unconventional gas producers, but conventional ones as well. The long-term fundamentals are still extremely bullish for natural gas. Many quality names are down 20 to 40 percent year-to-date. StockInterview: How do you view the long-term fundamentals for gas? Eric Nuttall: North American natural gas production has been in decline for several years. Most incremental production is coming from smaller, more expensive-to-drill, thinner economic, higher decline pools and reservoirs. Over the past five years first-year decline rates on natural gas wells have doubled to 50 percent. The base decline rate has also doubled to approximately 25 to 30 percent. Pool size has also decreased materially over that time frame. The Western Canadian Sedimentary Basin and much of the US producing basins are mature. Consequently, higher and higher natural gas prices are required to create incentive for producers to drill increasingly marginal wells. StockInterview: And you expect a continuation of declining natural gas production? And that is that your premise for higher natural gas pricing? Eric Nuttall: Conventional gas production has been in decline for many years, and the growth areas have largely been unconventional, such as the Piceance Basin (tight gas), the Barnett Shale (shale gas), and the Jonah Field (tight, deep gas). Also, many of the growth assets, such as the Barnett Shale, are already a few years into development, and because the wells have such a steep decline rate in the first few years, it is only adding to the depleting base that we have to make up. It is unlikely that over the next three years, the increase in unconventional gas can offset the decline in conventional, because the depleting base is so much larger. The major natural gas basins in North America are mature. Decline rates are increasing. Pool size is decreasing. Rig count is increasing yet production is at best flat. Until LNG imports increase in a material way, which is not expected for at least four or five more years, I think the case for healthy natural gas prices is intact. StockInterview: Earlier, you noted drilling was more expensive. Eric Nuttall: Over the past year, onshore drillings costs are up over 15 percent while operating costs are up over 10 percent. A recent Wall Street Journal article commented on how rig rates for the Gulf of Mexico, on very deep drilling platforms, are as high as $520,000 per day, up from $185,000 a few years ago. And the drilling platforms are still leaving the Gulf of Mexico! Although many are leaving the Gulf of Mexico to go to more prospective areas such as the West African Coast, the current rig situation is still somewhat tight in the Gulf. We have only begun to see signs of moderating rig rate pricing. StockInterview: How would bad weather, such as a hurricane, impact natural gas prices? Eric Nuttall: Short term, you would see both natural gas and related stocks surge. If a hurricane strikes the producing area of the Gulf, and we almost need one to – to correct the surplus supply situation. Initially, you’ll have an emotional upward response. Only after assessing the status of production platforms and sub-sea infrastructure would we know the longer-term impact. StockInterview: Should investors be watching the Weather Channel and ready to phone their stockbrokers? Eric Nuttall: Timing on any natural gas investment right now is tricky. You need to have a medium- to longer-term focus. We probably have another two months of volatility. There are two camps right now on natural gas. One camp is saying that due to bloated storage levels companies are going to increasingly lay down their drilling rigs, cut production guidance, and stress their balance sheets. Then in the fall, when companies set their 2007 budgets, they will be using low gas prices and presenting moderating production growth profiles to their investors. StockInterview: What does the other camp say? Eric Nuttall: Another camp says that the current natural gas strip already discounts the present and forecasted storage levels. Also, stocks are cheap on a price-to-cash flow and price-to-net asset value ratios, and now is the time to load up on the stocks. I lean towards this viewpoint. But I am also admitting that until the fall, barring a severe hurricane, it is likely that the stocks are going to trade sideways, as opposed to in any clear direction. StockInterview: One equities strategist, whom we interviewed, suggested some time in August we might start to see the natural gas stocks moving higher. Eric Nuttall: There is the potential that we might endure another month or two of flat trading in small cap natural gas stocks. By the end of August, it is likely that we will have had both a supply and demand response – worries of massive laying down of rigs, forced well shut-in’s, and overleveraged balance sheets should have subsided. Investors will begin to focus on the natural gas strip rather than spot prices, which currently are around $9.00 for the upcoming winter and $8.00 for next summer. StockInterview: And until then? Eric Nuttall: Until that time comes, I think it likely, as a group, the large caps will outperform. They are more weighted towards oil, and have recently been catching a bid on the heel of a huge $22 billion all-cash takeover by Anadarko of Western Gas and Kerr-McGee. Importantly for unconventional gas investors, Anadarko paid around $2.00 for 3P (Possible) Mcf, which is very healthy (Western Gas was predominantly tight gas in Wyoming and coalbed methane in the Powder River Basin). It speaks to Anadarko’s view of strong long-term natural gas fundamentals. These all-cash transactions likely set the bottom in the large caps. StockInterview: How do you feel about the smaller, lesser known gas companies? Eric Nuttall: Nearly all small-cap natural gas producers have taken it in the teeth this year. The price decreases in their stocks have been absolutely brutal. There are now companies whose stocks are down 40 percent year-to-date. They are still strongly growing production on an adjusted share basis. Yet, they are trading as low as 2.5 time 2007 cash flow. Many stocks have gotten incredibly cheap. Although the market might still be a bit sloppy for a few months, I think there are some great bargains to be had for the patient investor. StockInterview: How do you sum up the natural gas equities market, right now? Eric Nuttall: Currently, there are many very cheap natural gas weighted companies. Companies with active drilling programs, who are adequately financed and sitting on highly prospective acreage, are trading under three times 2007 cash flow. If the stock prices don’t improve for the juniors, I would expect many seniors and trusts will jump at the opportunity to acquire existing production below what current finding and development costs would require through exploration or development drilling. StockInterview: Let’s review some of the more speculative companies we talked about this past spring, such as Crew Energy, Rockyview Energy and Canadian Spirit. How do you feel about them now? Eric Nuttall: Crew (TSX: CR) is a very well run natural gas focused company. They are set to grow production per share over 40% this year and next, have a very active drilling program for the second half of the year. Canadian Spirit Resources (TSX: SPI) has been chopped in half from its peak, yet nothing but the price of natural gas has changed. We’re still quite bullish on Canadian Spirit. Their play is in early stages, and production and economic risks are still there, but if they can repeat their previous rates, I think they could have a very large and economic project. Rockyview (TSX: RVE) recently cut their drilling capex by 67% taking a bit of momentum out of the story short-term. With a recovery in natural gas, the stock should rebound along with the rest of the group. StockInterview: What unconventional companies are you following? Eric Nuttall: We are keenly following the drilling progress of EnCana (NYSE: ECA; Toronto: ECA) in the Columbia River Basin in Washington State. For an investor looking for a lower risk, relatively lower rate of return, EnCana is a great way for an investor to gain exposure to natural gas. They have around 95 percent of their 2007 natural gas hedged at slightly over $7 per mcf, so are protected from today’s brutalized spot price. Another is Calfrac (TSX: CFW), which is down 45 percent from its peak, and is now 10X 2007 earnings estimates. They are heavily exposed to CBM, and with a recovery in natural gas prices, the stock should recovery nicely. StockInterview: And some of the others we talked about, such as Ember, Real Resources and Pacific Asia China Energy. Do you have any updates? Eric Nuttall: Ember Resources (TSX: EBR) has gotten absolutely crushed. They have an active drilling program for the second half of the year. To fund it, they will likely need to seek further equity financing. This has created an overhang on the stock. Until they are able to execute some form of a financing, the stock might stay weak in the short-term. Real Resources (TSX: RER) has been executing well on their drilling program. Once a pipeline is completed in the next month, production should jump 37 percent to 16,500 Boe/d. The company sits on 450,000 net undeveloped acres, prospective for a variety of targets including Devonian Nisku, 190 Bakken light oil locations, and up to 1.1Tcf of recoverable CBM as assigned by Sproule. When trading at 3.5X 2007 cashflow, the stock presents a good opportunity. Pacific China Asia Energy (TSX: PCE) recently released data on three core holes revealing pretty good gas contents and seam thicknesses, as expected. The question still remains whether wells will produce at an economic rate, which you only know by drilling test wells. I think that’s scheduled for later this year or early next. They sit on what appears to be a very prospective land spread, and simply need the time to drill, and attempt to achieve economic rates across their acreage. StockInterview: What do you see for the near-term? Eric Nuttall: Many people have been hoping that warm weather or hurricanes would assist in working off the excess supply, but Mother Nature hasn’t been terribly helpful so far this summer. It appears that we will exit the natural gas injection season at least 10% over last year. Barring any incredible heat waves or significant hurricanes, natural gas prices are likely to remain sub-$6.50 until the fall. Unless we have a serious hot spell or a significant hurricane, it is likely that natural gas stocks will be very volatile without clear direction over the summer into the fall. I would think not until the fall, probably September – October, when people begin to focus not on natural gas spot prices, but on the strip pricing for the winter, which is still over C$10. Until that time comes, I wouldn’t see any clear direction in the stocks. The market is now providing opportunities to buy companies with high quality management for below-average multiples, commonly measured on a price-to-cash flow metric. StockInterview: Have you given up on the CBM sector or is it coming back? Eric Nuttall: There is zero doubt in my mind that natural gas is an excellent long-term investment. We’ve peaked in our ability to increase production meaningfully, just as we have with light oil. I think for there to be an increase in long-term natural gas supply, you have to provide incentive to producers to go drill wells that increasingly have lower economic rates of return. And to do that, you need higher natural gas prices. One of the few remaining growth prospects in Canada for natural gas production is coalbed methane. At current gas prices, the economics are very challenging. So to get a supply response from coalbed methane producers, you again need higher gas prices. The current surplus in gas storage will correct itself, and investors should position themselves ahead of natural gas stocks reacting to this inevitability.